Equity Structure of MNE Affiliates and Scope of Their Activities: Distinguishing the Incentive and Control Effects of Ownership

• Published date: 01 November 2014
• Date: 01 November 2014
• Author: Tailan Chi,Zheng Jane Zhao
• DOI: http://doi.org/10.1002/gsj.1083

EQUITY STRUCTURE OF MNE AFFILIATES AND

SCOPE OF THEIR ACTIVITIES: DISTINGUISHING

THE INCENTIVE AND CONTROL EFFECTS

OF OWNERSHIP

TAILAN CHI* and ZHENG JANE ZHAO

School of Business, University of Kansas, Lawrence, Kansas, U.S.A.

This study examines the effects of an MNE’s equity ownership on the scope of its affiliate’s

activities. We focus on architectural design and engineering (ADE) activities and distinguish

them from other activities because ADE capabilities are often core to the MNE’s competitive-

ness. Our empirical analysis, set in the Chinese automobile industry, reveals that the MNE’s

equity ownership tends to narrow the scope of an affiliate’s ADE activities while widening the

scope of other knowledge-intensive activities the two parties undertake jointly. The results

suggest that equity ownership enables an MNE to control more effectively the scope of its

affiliate’s ADE activities for better protection against leakage and, at the same time, motivates

the MNE to perform a broader spectrum of other knowledge-intensive activities at the affiliate.

Copyright © 2014 Strategic Management Society.

INTRODUCTION

A fundamental question in research on multinational

enterprises (MNEs) is concerned with the reasons

for a firm to engage in foreign equity ownership. One

of the basic reasons that the extant literature has

identified is the role of equity in facilitating the per-

formance of productive activities that can benefit

from the firm’s knowledge-based assets (e.g., tech-

nology) beyond its home country (Buckley and

Casson, 1976; Dunning, 1981; Hennart, 1982;

Rugman, 1981; Teece, 1977). Economic theories

consider equity ownership to serve two principal

functions. One function is the provision of control or

decision rights, because the arrangement entitles the

owner to a voice in the management of the entity

(Williamson, 1975; Williamson, 1985). The other is

the provision of incentives, because the arrangement

also grants the owner residual claims, i.e., rights to

the entity’s future cash flows and, thus, motivates it

to contribute inputs that are important to the entity’s

economic performance but are hard for others to

measure (Barzel, 1989). Although existing studies

tend to accentuate either the incentive or control

function, their predictions regarding equity owner-

ship’s effect on an MNE’s performance of

knowledge-intensive activities (KIAs) at its affiliates

are essentially consistent.1From a governance cost

Keywords: MNEs; incentive; control; equity ownership; China

*Correspondence to: TailanChi, School of Business, University

of Kansas, 1300 Sunnyside Ave., Lawrence, KS 66045, U.S.A.

E-mail: chi@ku.edu

1The term ‘affiliate’ can be defined in a narrowor broad sense.

The narrow definition refers to a company in which another

company holds a minority interest; the broad definition refers to

a company that is related to another company in some way

(with or without equity ownership). In this article, we use the

broad definition to refer to any local venture that receivesknow-

how inflow from an MNE, whose equity involvement in the

venture may range from zero to 100 percent. As pointed out by

Hennart (2009), an MNE’s expansion into a foreign location

fundamentally involves the bundling of its firm-specific assets

with certain location-specific assets in the host country.The use

of the broad definition of affiliates enables the current study to

Global Strategy Journal

Global Strat. J., 4: 257–279 (2014)

Published online in Wiley Online Library (wileyonlinelibrary.com). DOI: 10.1002/gsj.1083

Copyright © 2014 Strategic Management Society

perspective, the control rights embodied in equity

ownership enable the MNE to mitigate the hazards

of misappropriation by the recipients of its knowl-

edge in an affiliate and, thus, increase its willingness

to conduct KIAs at the affiliate (Anderson and

Gatignon, 1986; Davidson and McFetridge, 1985;

Oxley, 1997). From a measurement cost perspective,

the cash flow rights embodied in equity ownership

provide incentives for the sharing of tacit knowledge

that requires effort on the part of the MNE (Chi and

Roehl, 1997; Gomes-Casseres, 1990; Hennart,

1991).

As Oxley and Sampson (2004) pointed out,

however, MNEs often have two conflicting goals.

One goal is to provide its foreign affiliates with the

relevant knowledge that can enhance their economic

performance; the other is to prevent its most prized

trade secrets from unintended leakage to existing or

potential competitors. Most extant empirical studies

have focused on testing the proposition that equity

ownership motivates an MNE to share its knowledge

in a broader range of KIAs at its affiliate, with

limited attention paid to the impact of equity own-

ership on its ability to limit unintended leakage of its

trade secrets. An exception is the recent study by

Oxley and Wada (2009), which uncovered evidence

that equity joint ventures (JVs) are more effective

than licensing agreements in promoting intended

knowledge transfer and in limiting unintended

leakage. One question that still remains, however, is

how equity ownership enables the MNE to control

leakage. A tantalizing hint comes from an earlier

study by Oxley and Sampson (2004), which finds

that alliances between firms that compete in either

product or resource markets tend to have a narrower

scope of activities, perhaps for fear of unintended

leakage of proprietary knowledge. As an intermedi-

ate outcome of the collaboration between the MNE

and its affiliate, the scope of the affiliate’s activities

reveals important information about the process in

which the parties manage their collaboration in the

face of hazards for rent misappropriation.

The present study pursues this line of inquiry

further. Specifically, we examine whether equity

ownership enables an MNE to control more effec-

tively its affiliate’s scope of those KIAs that involve

its most prized trade secrets, while at the same time

motivating the MNE to assist the affiliate in a

broader scope of other KIAs. We accomplish this by

distinguishing architectural design and engineering

(ADE) activities from other KIAs because it is often

the firm’s ADE capabilities that enable an MNE to

develop successive generations of superior product

architectures with seamless system integration and

maintain its competitive advantage.As demonstrated

in a recent study by Jacobides and MacDuffie

(2013), firms in a variety of industries, including

automobiles and smartphones, have succeeded in

retaining their roles as irreplaceable system integra-

tors by keeping their ADE capabilities proprietary.

ADE capabilities are part of a firm’s architectural

competencies (Henderson and Cockburn, 1994;

Henderson and Clark, 1990), but are more limited in

scope, reflecting only those capabilities that are criti-

cal to the development of new generations of com-

petitive products. By scrutinizing whether an MNE’s

equity ownership has differential effects on the

scope of its affiliate’s ADE activities and the scope

of the affiliate’s other KIAs, we uncover evidence

that equity control enables the MNE to limit more

effectively the scope of its affiliate’s ADE activities

for the protection of its most prized trade secrets.

Our study also contributes to the understanding of

the distinct incentive and control functions of equity

ownership in facilitating the performance of KIAs in

international business. As noted earlier, extant

studies have, in general, predicted that the incentive

and control functions of equity ownership have the

same positive effect on a single outcome variable—

typically some measure of knowledge flow from the

MNE to its affiliate or the MNE’s willingness to

conduct knowledge-intensive activities at the affili-

ate. As such, the control effect of equity ownership

cannot be examined separately from the incentive

effect. The recent study by Oxley and Wada (2009)

suggests that it is possible to tease out their separate

effects by examining two outcome variables that the

two functions of equity ownership are predicted to

influence in opposite directions. By examining the

opposing effects that an MNE’s equity ownership is

expected to have on the scope of its affiliate’s ADE

activities and the scope of the affiliate’s other KIAs

in the context of an emerging economy, our study

aims to gain further understanding of the differential

roles of the two functions. The empirical findings of

this study confirm our predictions, yielding evidence

that higher MNE equity ownership can have oppo-

site effects on the scopes of two different types of

investigate how the variationwithin the full range of ownership

structures for asset bundling affects a key intermediate

outcome—the scope of the affiliate’s activities—that reflects

the process in which the MNE and its affiliate manage their

collaboration.

258 T. Chi and Z. J. Zhao

Copyright © 2014 Strategic Management Society Global Strat. J., 4: 257–279 (2014)

DOI: 10.1002/gsj.1083